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Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

All investing is subject to risk, including the possible loss of the money you invest.

The issues aren’t quite the same as those one faces when considering the deepest aspects of personal faith and religious doctrine, but a “Roth conversion” can pose some difficult issues for investors nonetheless. And we’re going to hear much more about this going forward because of a scheduled change in the law: Unless something unexpected happens in D.C., come 2010 there will no longer be income limits on Roth IRA conversions.

There will be a lot written on the issue of whether one should convert or not, as well as endless articles describing all kinds of “strategies” to potentially leverage the change (some legitimate and others more questionable). For me, three things are important in considering this kind of “conversion”:

1. First and foremost is how strongly you feel about your future income tax rates. If you feel strongly that there is a significant chance your income tax rates will be higher in the future, then having some money in a Roth allows you to “hedge” that risk by paying taxes at today’s rates. Of course, you should note that while the Roth rules currently stipulate that no income taxes are owed on qualified Roth withdrawals, tax laws can change. So while the Roth clearly offers some protection from taxes, it’s not an ironclad guarantee.

2. Second is that you have to recognize that $1 of after-tax wealth is more than $1 of before-tax wealth. What this means is that by converting a $10,000 pre-tax IRA to a $10,000 post-tax Roth IRA, you have effectively put more resources into your IRA account. An example: If your income tax rate is 25%, your $10,000 pre-tax IRA is worth $7,500 of goods and services. Your $10,000 post-tax Roth is worth $10,000 of goods and services. In other words, even if the dollar amounts in traditional and Roth accounts are the same, the Roth gives you an ongoing tax break on “more” wealth. This is why, to properly compare the tax advantages of the two dollar-for-dollar, most quantitative analyses of Roth versus traditional—including Vanguard’s—include a taxable “balancing account” along with the traditional IRA. What you see is that if tax rates don’t change over time, the two IRAs actually offer identical tax benefits per dollar of after-tax IRA wealth. It’s just that you can generally get more after-tax wealth into a Roth. In practice, most people in the real world aren’t going to set up an additional savings account alongside their traditional IRA. So a Roth conversion is a great chance to save more, assuming you can pay the taxes you’ll owe on the conversion from a source other than the converted IRA.

3. A last consideration is how focused you are on spending the money in retirement. A big advantage of a Roth IRA is that you don’t have to take minimum distributions in your lifetime. That means you can keep the money in the “tax-free” wrapper a very long time. This is less of an advantage if you see yourself spending regularly from your IRA in retirement.

Obviously, everyone should consult a tax advisor about his or her own situation. But a Roth conversion in 2010 could offer some significant benefits to a lot of investors. And in all the noise and “strategizing” you’re going to hear in upcoming months, it may be important to stay focused on the basic issues.

Like this:

John Ameriks

John Ameriks oversees the Active Equity Group within Vanguard Equity Investment Group, which manages active quantitative equity fund assets. He is one of Vanguard's thought leaders on retirement issues and has conducted studies on a wide range of personal financial decisions, including saving, portfolio allocation, and retirement income strategies. John came to Vanguard in 2003 from the TIAA-CREF Institute, the research and education arm of TIAA-CREF. He graduated from Stanford University with an A.B. and earned a Ph.D. in economics from Columbia University.

Comments

Richard G. | July 24, 2017 2:23 pm

Mr. Ameriks: I have a question about a statement in your article in section 2.i understand the part where if you are in the 25% tax bracket a $10,000contribution to a before tax bracket is worth $7,500.00.Then you made a statement that a $10,000.00 Roth contribution is worth $10,000.00. Aren’t you forgetting that you have to pay the tax BEFORE you put the money in?So the whole $10,000 is not going into the account during the accumulation phase.Where the Roth pays off is during the withdrawal phase it seems to me.Vanguard is a proponent of taking a middle of the road approach and they have been telling or encouraging their clients for the past 40 plus years to not ever put all of your investments into one basket but several baskets.This need for converting needs to be thoroughly researched BEFORE you begin the conversion.Investors who are in the lower tax brackets may noy benefit from a conversion at all.I personally have a traditional IRA with Vanguard. I trustee to trustee transferred 44 years of my life’s savings with the Fed’s to Vanguard in 2010.We start RMD’s in 2018 and I will have no problem paying the taxes on my withdrawals one year at a time. A great article!

Linda M. | March 2, 2017 10:16 am

I will be 62 this year and am mostly retired except for a small part-time job. Only 3% of my IRA assets are ROTH. I have only enough taxable funds for the current year, not enough to pay ROTH conversion taxes from taxable funds. Nevertheless I am virtually positive I will be in a higher tax bracket at age 70 than I am now when I begin taking social security and come into some inheritance. Does the admonishment to only convert to ROTH if you can pay taxes from taxable funds hold in this situation. I expect to have enough traditional IRA funds to leave all or most of ROTH to children even if I convert up to 10% and live to 105, like my grandmother.

DONALD S. | April 11, 2015 2:21 am

Answer to: David P 2/24/2014, Your question: Is money spent Roth converting IRA funds as good an investment as adding money to taxable investment accounts? Answer: Yes, if you are willing to take a $10,000 risk , as I did for eight years in a small cap co, ALNY, and then sell for $130,000+ in 3/19/2015. I paid no Fed. tax and had a target to pay off our mortgage. So, do your investing homework, check the company’s balance sheet quarterly and follow all company news and developments and most of all: be patient! Prices go up and down. However, if you have a longer time frame to invest, stay with Vanguard funds and be an easy winner!

Anonymous | February 29, 2012 4:08 pm

Good Day,

Regarding conversions from a Traditional to a Roth IRA, it would be grand if you could clearly express if the maximum yearly contribution level of 5k applies to both ” annual contributions” after the conversion is completed as well as/as not the converted amount…In other words if I wanted to initially convert/rollover 10k, is this possible since the “rollover” amount is not being pulled from current year net earnings?

Also, please explain the flexibility of dividing a current IRA into mulitiple IRAs all at once. How long must one wait before re-converting/re-rolling over one IRA into another?

Always please “clearly express” a universal sample of: all upfront rollover fees, ongoing operating fees, annual fees…right up front on the Vanguard Home Page, rather than causing a prospective customer to fish for hours on your internet site!

Anonymous | December 8, 2010 12:00 pm

Anonymous | November 17, 2010 11:56 am

One of the issues I have not seen addressed is whether conversion to a Roth might increase one’s AGI in the year of conversion high enough to require additional tax payments due to the Alternative Minimum Tax (AMT) provisions currently in place. If so, the initial tax of conversion may be significantly greater than reflected in straight rate comparison tables.

Anonymous | October 30, 2010 9:42 pm

I am following a similar plan to that of the individual that posted on 10/23/2010 at 2:08 pm. I am slowly converting my Traditional IRA assets into Roth assets – primarily (though not solely) for purposes of estate planning. Otherwise ultimately my heirs must pay income taxes, as a result of my choice to defer the income taxes associated with these assets.

I have been incrementally accomplishing this conversion process for some time now, and I am careful to convert just enough each year to always remain in my planned tax bracket. And the prior poster was correct – if RMDs are required to be processed, the RMDs cannot be part of the Roth conversion. In order to facilitate this annual conversion effort, I have converted most of my non-IRA income-producing assets into muni-bonds. Because I do not pay income tax on this income, it permits me enough room within my tax bracket to convert a fairly large portion of Traditional IRA assets each year into Roth assets. I have calculated that the conversion process should be totally complete about 15 years from now. Chances are that either my wife or I (or both of us) should still be around to finish it by 2025. And Roth IRAs will be so much more valuable and easier for the children to manage.

Anonymous | October 23, 2010 2:08 pm

My reason for converting to a Roth is for estate planning. I’m doing it in stages to minimize tax consequences. I am POSITIVE that taxes will rise and my kids would be paying much more after my passing! I have never seen taxes decreasing, locally or federally, thanks to our politicians! I won’t be spreading this year’s conversion over 2 years because I’ll be putting in similar amounts year after year. We are fortunate (frugal) enough that we take the MRD only because it’s required by law. Just make sure that the rollover is not part of your MRD.

Anonymous | October 21, 2010 9:50 am

Re Oct. 1 blog: I recently contacted IRS concerning estimated tax requirement on the conversion. I gave the agent numbers from last year’s return plus the amount I was going to convert. She ran the numbers and told me that I didn’t have to pay the tax until I file in April, 2011. (I just hope she right!)

Anonymous | October 1, 2010 10:51 am

I know I want to declare my conversion income as 2010 income. . . however, I’m having a hard time finding a good answer as to when during the year (or even in 2010 vs. when I file in 2011) I needed to pay estimated tax to avoid potential underpayment penalties. . .

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For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

All investing is subject to risk, including the possible loss of the money you invest.